At Stake: Dividends Make Up 90% of Total Return

If Congress fails to extend the Bush tax cuts on dividend income, they will be taking a direct hit at the most important part of an equity investment, one which accounts for nearly all of its return.

“Some may be surprised to learn that 90 percent of U.S. equity returns over the last century have been delivered by dividends and dividend growth,” said BlackRock’s Richard Turnill and Stuart Reeve, in a report to clients today advocating investment in dividend stocks. They head the global equity team for the world’s largest money manager.

Congress is reportedly close to a bipartisan agreement on the Bush tax cuts, including the dividend tax. The agreement would extend them for all income brackets for at least a year. President Obama said in a press conference today that he doesn’t want taxes to go up next year for “ordinary Americans.”

The potential compromise couldn’t come at a more crucial time for stock investors. The total return for equities is determined by price appreciation and dividend income. Following a decade of zero total price appreciation and a rejection in the boardrooms of dividends as an effective allocation of capital, the BlackRock strategists say the time is right. They cited the low-yielding investment alternatives out there, an aging baby boomer population that will crave that dividend income, and an economic outlook for slow growth.

“For income-oriented investors, the closing of the gap between dividend and bond yields has prompted many to consider the benefits of taking a yield approach to equity investing, after many years in which dividends lost favor: both in the boardroom and among the investment community,” said Turnill and Reeve, in the note.

Dividends lost their luster during the technology bull market as a good growth story was enough for investors to keep bidding the shares higher. Apple still does not pay a dividend. But the BlackRock data shows that over the long, long term, through bull and bear markets, dividends matter most. And now they’re in the crosshairs of Congress.

“We believe that the dividend and capital gains rates will remain at 15 percent as part of any final compromise” for one to three years, said Ed Mills, FBR Capital Markets policy analyst, in a note today. “This is based upon the unwillingness of Senate Republicans and several Senate Democrats to vote on any proposal that would increase taxes. Even an increase to 20 percent could be spun as a tax increase of 33 percent, something they would not like to see as part of a political ad against them in the next election.”

If you take a tax rate increase off the table, then dividend-paying stocks may be the way to go. Tobacco company Reynolds American Inc. said today that it would pay 80 percent of 2010’s profit to shareholders in the form of dividends.

“With government yields plummeting around the world, and interest rates possibly staying low for a significant length of time, expectations are rising for a period of below-trend growth and possibly deflation,” said the BlackRock strategists. “We believe those higher-yielding companies that recognize the lower-growth environment and commit to realistic dividend growth will be much better positioned to outperform than those companies that use their cash on balance sheet to grow through acquisitions.”

The BlackRock report showed that the long-term benefit of dividends is not just a U.S. phenomenon. Since 1970, more than 80 percent of European equity returns came from dividend yield and growth, it stated, citing data from GMO.

“With long end rates going up, this may not be the perfect entry point,” said James Iuorio, a trader for TJM Institutional Services, who said he was surprised by the magnitude of the 90 percent BlackRock figure. “However, with the 10-year Treasury below 4 percent, the dividend payers remain attractive longer term. I particularly like defensive names like McDonalds ,Procter & Gamble and Colgate-Palmolive .”

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